Lloyds (LSE: LLOY), HSBC (LSE: HSBA) (NYSE: HSBC.US) and Santander (LSE: BNC) (NYSE: SAN.US) are all in the final stages of recovery from the financial crisis.
However, due to an increasing regulatory burden, these banks are unlikely to ever return to their pre-2008 glory days, when bankers and investors alike reaped rich rewards.
Increasing pressure
The latest assault on banking profitability comes in the form of government enforced ringfencing. Under new rules, banks will be forced to ringfence their retail and wholesale banking operations. This is intended to reduce consumers’ exposure to risky investment banking operations.
But this ringfencing will be…

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However, due to an increasing regulatory burden, these banks are unlikely to ever return to their pre-2008 glory days, when bankers and investors alike reaped rich rewards.

Increasing pressure

The latest assault on banking profitability comes in the form of government enforced ringfencing. Under new rules, banks will be forced to ringfence their retail and wholesale banking operations. This is intended to reduce consumers’ exposure to risky investment banking operations.

But this ringfencing will be a costly process. Indeed, the new wholesale entities must, by law, be run separately from the parent, requiring separate directors, IT systems and risk and finance functions. It is likely that significant one off costs will occur as a result.

Furthermore, the separation will remove any cost savings synergies and efficiencies that would have been achieved by having both retail and wholesale operations under one roof.

The most to lose

Unfortunately, Santander UK and Lloyds stand to suffer the most from this enforced ringfencing. The two banks have the smallest wholesale banking operations out of the UK’s banks sector. So, for Lloyds and Santander UK, the costs of separation — as a percentage of income — will be large.

Of course, there is another option. Santander and Lloyds could just sell, or spin off their wholesale operations, rather than incurring additional costs by separating them.

Whatever the case, the wholesale arms of Santander UK and Lloyds face an uncertain future and this is bound to have an impact on the profit margins of the two banks.

Parent support

Luckily, Santander UK will be able to rely on support from its parent company to foot the bill for regulatory costs. The eurozone’s biggest bank, Santander recently reported a 38% rise in second-quarter profit. The bank’s first half net income jumped 22% to €2.8bn. Additionally, provisions set aside for delinquent and defaulted loans fell 22% from €3.5bn, to €2.6bn.

Nevertheless, even large international banks like Santander are felling regulatory pain. Indeed, HSBC has already warned that rising regulatory costs are putting the bank under immense strain. HSBC has one of the largest wholesale banking arms in the UK, so the bank is only likely to see costs rise.

For investors, this is bad news. HSBC recently reported a 12% fall in first half profit thanks to rising regulatory costs. Management stated that HSBC is now spending $800m a year more on compliance across its global operations than reported during 2011. Costs are only set to rise and profits will fall further as a result.

Dividend plans

While Santander UK can rely on its parent to foot the UK regulatory bill, Lloyds is not so lucky and as well as an increasing regulatory burden, the bank is now having to fight investors.

Specifically, the bank is currently facing charges and is being sued by a group of investors, over the government-arranged takeover of HBOS by Lloyds TSB at the height of the financial crisis in 2008.

The claimants are seeking upto £12bn in damages, making it one of the largest payouts in the UK’s history, and, unfortunately, if forced to pay out, Lloyds’ dividend plans would have to be scrapped. A £12bn payout would put a huge dent in bank’s capital cushion.

Nevertheless, before making any trading decision, I strongly suggest you take a closer look at Lloyds.

This exclusive FREE wealth report provides six key 'City insider' valuation metrics for each bank traded in London. That's right, the report is not just limited to Lloyds -- it gives a rundown of the whole industry.

The results are surprising -- and revealing. This report is free and without obligation. To get your copy, click here.

Rupert Hargreaves has no position in any shares mentioned. The Motley Fool has no position in any of the shares mentioned. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.

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